I am a Tax Partner in WithumSmith+Brown’s National Tax Service Group and the founding father of the firm's Aspen, Colorado office. I am a CPA licensed in Colorado and New Jersey, and hold a Masters in Taxation from the University of Denver. My specialty is corporate and partnership taxation, with an emphasis on complex mergers and acquisitions structuring. In the past year, I co-authored CCH's "CCH Expert Treatise Library: Corporations Filing Consolidated Returns," was awarded the Tax Adviser's "Best Article Award" for a piece titled "S Corporation Shareholder Compensation: How Much is Enough?" and was named to the CPA Practice Advisor's "40 Under 40."

In my free time, I enjoy driving around in a van with my dog Maci, solving mysteries. I have been known to finish the New York Times Sunday crossword puzzle in less than 7 minutes, only to go back and do it again using only synonyms. I invented wool, but am so modest I allow sheep to take the credit. Dabbling in the culinary arts, I have won every Chili Cook-Off I ever entered, and several I haven’t. Lastly, and perhaps most notably, I once sang the national anthem at a World Series baseball game, though I was not in the vicinity of the microphone at the time.

Economic performance with respect to LP1′s liability for drilling and development services provided to LP1 by Z occurs as the services are provided. Consequently, $200,000 is incurred by LP1 for the 2015 taxable year. Thus, LP1 may not deduct any accrued liability for the well booked at December 31, 2013.

In order for the recurring item exception to be applied to these types of liabilities, economic performance must occur within the earlier of:

8 ½ months after year-end, or

The filing of the tax return.

This is where tax advisors always go wrong. Consider the following example:

On December 31, 2013, X Co. accrues a $50,000 liability to A. A has provided advertising services to X Co. for years. The $50,000 accrued liability is for services to be provided in January 2014.

As seen above, under the general rules of Reg. Section 1.461-4, the $50,000 accrued liability would not be deductible on X Co.’s 2013 tax return, because economic performance will not occur until A provides the services during 2014. X Co. can use the recurring item exception to deduct the liability, however.

In determining the deductible amount of the accrued liability, tax advisors often make the mistake of asking the client to provide the amount of the liability that will be paid within the shorter of 8 ½ months of year-end or the extended due date of the tax return. What’s the problem?

Remember, to use the recurring item exception, economic performance must occur within the required time period. For this type of liability, however, the payment of the liability does not equate to economic performance. Rather, it is the provision of the services by the other party that gives rise to economic performance.

Thus, the question we must ask when determining the deductibility of an accrued service liability to an outside party is not whether the liability will be paid shortly after year-end, but rather whether the services will be provided within the earlier of 8 ½ months of year-end or the filing of the tax return.

Circling back to our example above, as long as the advertising services will be provided by A, the advertising firm, within the earlier of 8 ½ months of year-end or the filing of the return, X Co. may deduct the $50,000 accrued liability under the recurring item exception.

Questions you must ask to procure a tax deduction for the accrued liability: Have the services giving rise to the liability been provided by year-end? If not, will they be provided within the earlier of 8 ½ months of year-end or the filing of the tax return?

Accrued Compensation, Bonus, Vacation, Severance

Here’s where things get a little tricky, and as a result, mistakes are easily made. These items represent amounts owed to an employee for services provided, and thus are considered “deferred compensation” unless otherwise exempted by statute.

The timing of deductions for deferred compensation is governed by Section 404 rather than Section 461. In general, deferred compensation is not deductible until the recipient includes the amount in income. Because all individuals are cash basis taxpayers, the employer is generally not entitled to a deduction for deferred compensation until the amounts are paid, because that is when it will be included in the income of the recipient. Thus, barring an exception, no amount of a liability for accrued compensation-type items would be deductible at year-end.

An exception to this general rule is found under Proposed Reg. Section 1.404(b)-1T Q&A 2, which excludes from the definition of deferred compensation amounts that are paid to the service provider within 2 ½ months of year-end.

Putting this all together, if year-end accruals for compensation, bonuses, vacation or severance are not paid within 2 ½ months of year-end, they are considered deferred compensation under Section 404, and are thus not deductible until paid. If, however, the liabilities are paid within 2 ½ months of year-end, the amounts are not deferred compensation. Then, the analysis turns to whether economic performance has occurred.

As indicated in the previous category, economic performance occurs with respect to a liability owed by the taxpayer for services to be provided to the taxpayer when the other party actually performs the services. As a result, if the accrued year-end compensation is intended to compensate the employee for services already rendered, then economic performance has occurred, and provided the amounts are paid within 2 ½ months so as to remove the liabilities from the definition of deferred compensation, the taxpayer is entitled to the deduction.

Example: On December 31, 2013, X Co. accrues a $50,000 bonus to employee A for services provided during 2013. The bonus will be paid on February 22, 2014. X Co. may deduct the $50,000 on its 2013 tax return.

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